For two decades, India has successfully used a targeted research and development (R&D) tax credit policy to encourage innovation in key sectors. According to new research co-authored by SFS Professor Rubina Verma, the policy had a differential impact: small and medium firms broadened their product offerings, while larger companies focused on improving product quality. This led to a drop in the aggregate price index and generated significant welfare benefits. Verma answered a few questions about the research, including the policy’s reach, its effect on the Indian economy and its potential international implications.
Q. What does India’s R&D tax credit policy entail?
A. Our paper focuses on the period from 1992 to 2007. In 1997–98, the government of India introduced a fiscal incentive in the form of a 125% tax-weighted deduction given to selected firms on their R&D revenue or capital expenditure. This deduction was only given to firms belonging to select industries—drugs and pharmaceuticals, chemicals, electronic equipment, computers and telecommunication equipment—and to those that had existing in-house R&D units and were registered with the Department of Scientific and Industrial Research (DSIR), the nodal unit in India’s Ministry of Science & Technology. In 2001, this tax-weighted deduction for those firms was increased to 150%. The scheme was also extended in 2001 to include helicopters and aircraft and in 2004 to include automobiles and auto parts. If a firm belonged to the above selected industries but lacked an in-house R&D facility, then the tax weighted deduction was the regular amount of 100%. Similarly, if there was a firm that did not belong to the selected industries, they, too, were only eligible for the regular tax exemption of 100%.
Q. How did you approach your research on this topic?
A. Our approach had two parts. In the empirical approach, we first analyzed Indian firm-level data from the PROWESS database. This dataset provides updated, detailed information on all listed firms and a larger set of unlisted firms across all sectors of the economy from the early 1990s to the present day. These firms are predominantly private Indian firms or are affiliated with private business groups, with a small fraction being either government- or foreign-owned. The data are compiled from audited annual reports of firms and information submitted to India’s Ministry of Corporate Affairs (MCA). The dataset provides information on a variety of firm-level characteristics, such as total sales, exports, imports, raw materials expenses, capital employed, labor costs, gross value added and assets. The second part involved developing a theoretical model with multi-product firms, flexible manufacturing and phased introductions of R&D tax credits.
Q. Did any of the results surprise you, and why?
A. These results imply that firm size and firm cost structure matter. There is a small growing body of literature on India that shows that policy effects depend primarily on firm size—Chaurey (2015); Chakraborty et al. (2024); Verma and Jin (2025). In that sense, the results of this paper align with expectations about the impact of policy on Indian firms. However, our results are novel as they show that firms of different sizes measured by the magnitude of their R&D expenses behave differently while investing their R&D resources.
Q. What have been the impacts of this policy for the Indian economy?
A. Our work shows that industrial policy in the form of R&D tax incentives can yield different outcomes for firms at different levels of R&D distribution, leading to distinct types of gains from a single policy. We find that small- and medium-sized firms optimize their R&D investments by expanding their product range, while larger firms—with R&D expenditures exceeding 50 million INR—optimize these investments by improving the quality of their product range. This effect is magnified for firms with access to a larger market size or firms that export and/or produce differentiated products. In addition to stimulating firm-level innovation, these R&D tax credits also yield substantial consumer welfare gains through improved product quality, expanded variety and lower prices. Thus, we argue that developing countries, like India, should actively promote such policies in order to increase not only the innovation expenses of firms or the country in question, but also for the larger objective of welfare gains associated with such policies.
Q. Why are these results significant on an international scale?
A. Our results show that industrial policies can affect firm performance. Governments are increasingly adopting targeted industrial policies, such as R&D tax incentives, to catalyze innovation within firms and across strategic sectors. Although there is substantial academic work showing that R&D tax credits stimulate firm-level innovation in areas such as R&D expenditures, patenting activity and entrepreneurship—Dechezleprêtre et al. (2023); Bloom et al. (2002); Rao (2016); Melnik (2024)—much less is known about the form these innovation investments take in terms of product development. Specifically, it remains unclear whether firms predominantly invest these resources in expanding product variety or improving the quality of existing products. In addition, these strategic choices may also involve trade-offs. Investments in product diversification could come at the expense of quality improvements. Our work helps one understand whether the type of R&D investments varies systematically with the size of the firm, and whether such trade-offs are essential to designing R&D incentive policies that maximize both private and social returns to innovation. Personally, I am interested in assessing the impacts of trade and industrial policies on firms and in examining how results vary across firms of different sizes in South Asian economies. While this research project focuses on formal firms, my broader agenda is to study informal, small firms, which are the dominant form of enterprise in South Asia.